24 Apr 2023
Climate change and the transition to net zero is an increasingly important theme for investors. Significant action is required to reduce our greenhouse gas (GHG) emissions throughout the world. We expect the scrutiny by regulators and underlying pension scheme members of climate-related exposures to only increase. This raises the question how climate change can be incorporated within portfolios, including fixed income portfolios.
How can investors go about determining whether a company is well aligned with the transition to net zero? At Aegon Asset Management, portfolio managers are working closely with our responsible investing team to build a forward-looking framework that will evaluate a company’s alignment with the transition to net zero.
What does that process look like? Every company gets a base assessment of its climate transition readiness by looking at three things: ambitions or targets with regard to GHG emission reductions, their current level of GHG emissions, and overall management policies towards climate transition. Every company is then categorized using a 1-5 scale from leaders to laggards – respectively those that are ready for a low-carbon future and those that are not. This can be used across different fixed income asset classes but so far, we have implemented this analysis into a global short-dated investment grade bond portfolio.
2022 saw a significant move higher in base rates around the globe, as central banks sought to bring inflation under control. This is reflected in the dramatic shift higher in yields. Turning more specifically to the opportunity in credit, incremental yield remains available in high quality investment grade bonds compared to underlying risk-free assets. Credit spreads increased over this period – reflecting both the increase in underlying interest rate volatility we have seen in 2022, and the deteriorating economic outlook and its potential to impact company balance sheets. While such risks warrant close monitoring, investment grade credit fundamentals are in relatively good shape, and we expect companies to be able to manage their balance sheets and liquidity appropriately.
Most companies are at relatively early stages of transition planning. More companies are now beginning to make commitments to emission reduction targets. Although transition plans need to go well beyond emission reduction targets, they also act as a good first step to assess whether the plan itself is robust and credible. The plan can only really be credible if the target itself is ambitious enough. On the target-setting piece of the strategy, we first like to see long-term commitment to net zero, but also robust targets set, more in the short to medium term. It is important to see deep reductions in emissions over the next decade if we are to meet the goals of the Paris Agreement.
Investment grade fixed income is dominated by financial companies. Although they typically have very low carbon footprints, they play a very important role in financing sectors that may be exposed to climate risks. Understanding the financials and what they are doing regarding climate change is very important for fixed income. That is why the major financial sectors are included in our high-influence sectors. Data quality in investment grade is pretty good, but less reliable in other parts of fixed income, such as high yield and emerging markets. It is not like listed equity, where the level of disclosure is always very high. Engagement can also be a challenge as a bond investor, and we need to look closely at how we engage with companies on climate transition matters. We aim to engage with those companies that rate poorly within our framework to encourage them to commit to more robust plans that will support climate transition.
We look back five years at scope 1 and 2 emissions for every issuer, essentially to check they are included within the base assessments, where we look at target setting and emissions performance. With scope 3 emissions, which are far broader, things become more dispersed when it comes to coverage. Where scope 3 emissions are the key issue for a company in terms of materiality and that issue can reduce those emissions, we focus on scope 3 emissions as the key issue there. We then take a deep dive in terms of the targets. Have they set scope 3 targets and are they looking at the right thing? Is strategy aligned to those scope 3 targets?
There are two key risks – inflation, and a potentially much deeper recession across Europe, the US, and the UK. With respect to the inflation picture, if higher inflation does transpire from here and persist, it will force central banks to raise rates further beyond current market pricing. With the recessionary outlook, we anticipate a marked downturn next year, but not perhaps something to really threaten the investment grade space. We are not overly concerned about recession risks from an investment grade perspective, largely because most companies are in a robust place going into this period. While we are keenly monitoring these risks, our view remains constructive on this part of the market for 2023.
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